Arnold Kling  

Acemoglu on the Economy and Economics

More Laughs in Economics... Be Careful What You Wish For...

Daron Acemoglu has written an essay on what the financial crisis means for economics. Highly recommended. I will excerpt and comment extensively. Thanks to Acemoglu's frequent collaborator Simon Johnson for the pointer, which I picked up from Mark Thoma.

In case you didn't know, Acemoglu is a recipient of the John Bates Clark medal, an award given every other year (the frequency will now be increased to once a year) to the American economist under 40 with the greatest contributions. Within the profession, the Clark medal is at least a prestigious as the Nobel Prize.

Acemoglu writes,

We believed that through astute policy or new technologies, including better methods of communication and inventory control, the business cycles were conquered. Our belief in a more benign economy made us more optimistic about the stock market and the housing market. If any contraction must be soft and short lived, then it becomes easier to believe that financial intermediaries, firms and consumers should not worry about large drops in asset values.

I would add that we also believed that better monetary policy had conquered the business cycle.

better diversification also creates a multitude of counter-party relationships. Such interconnections make the economic system more robust against small shocks because new financial products successfully diversify a wide range of idiosyncratic risks and reduce business failures. But they also make the economy more vulnerable to certain low-probability, "tail" events precisely because the interconnections that are an inevitable precipitate of the greater diversi…cation create potential domino e¤ects among financial institutions, companies and households. In this light, perhaps we should not find it surprising that years of economic calm can be followed by tumultuous times and notable volatility.

He is suggesting that institutions and contracts that make the economy more robust with respect to small shocks can actually increase systemic fragility. Although this may be true, I find it hard to think of a good way of addressing it.

I think that part of the problem is the way that risks are measured and disclosed. When it comes to financial institutions, there are few issues as tricky as the Risk Disclosure Problem. It frustrates me when people keep saying, "the solution is more transparency," or "we need more transparency," as if they are offering a useful, constructive suggestion. You might as well say "the solution is for everyone to be rich" or "we need world peace." Unless the person is making specific recommendations regarding risk metrics or financial reporting, anyone who says that we need more transparency is just a blowhard. In contrast with the blowhards, Acemoglu is doing the right thing and asking people to think about hard problems.

Much of creative destruction takes place at the micro level. But not all of it. Many companies are large and replacement of their core businesses by new firms and new products will have aggregate implications. Moreover, many general-purpose technologies are shared by diverse companies in different lines of businesses, so their failure and potential replacement by new processes will again have aggregate ramifications. Equally importantly, businesses and individuals make decisions under imperfect information and potentially learning from each other and from past practices. This learning process will introduce additional correlation and co-movement in the behavior of economic agents, which will also extend the realm of creative destruction from the micro to the macro.

What he seems to be suggesting here is that there are real business cycles, due to creative destruction, and these real business cycles will not necessarily be low in amplitude.

Sure enough, institutions have received more attention over the past 15 years or so than before, but the thinking was that we had to study the role of institutions to understand why poor nations were poor, not to probe the nature of the institutions that ensured continued prosperity in the advanced nations and how they should change in the face of ever evolving economic relations.

His point is that we should not get complacent about institutions. They may seem to work for a while, but then something changes and they do not.

I have very strong beliefs on this point. It is my view that incentive systems degrade over time, as agents learn to "game" the system. Within a firm, it is up to managers to identify the problem and change compensation systems in a timely fashion. Unless they constantly adjust their internal incentive structures, firms will find that employees learn to achieve more and more personal gains with less and less contribution to corporate profits.

The same holds true for regulation--in theory, regulators need to change their systems as private actors learn to game them. In practice, it is very difficult for regulatory agencies to move quickly enough, particularly when the political process is heavily biased toward the status quo.

Our logic and models suggested that even if we could not trust individuals, particularly when information was imperfect and regulation lackluster, we could trust the long-lived large …firms, companies such as the Enron's, the Bear Stearn's, the Merrill Lynch's, and the Lehman Brothers's of this world to monitor themselves and their own because they had accumulated sufficient "reputation capital".

I would say that the real poster children for companies that threw away their "reputation capital" would be the bond rating agencies, like Moody's. I also think that Freddie Mac and Fannie Mae paid little attention to their "reputation capital." When I was at Freddie, the CEO understood that we had a valuable reputation for safety and soundness. Several years after I left, he was replaced, and his successor did not seem to care so much about safety and soundness.

reputational monitoring requires that failure should be punished severely. But the scarcity of speci…fic capital and know-how means that such punishments are often non-credible. The intellectual argument for the fi…nancial bailout of the Fall 2008 has been that the organizations that are clearly responsible for the problems we are in today should nonetheless be saved and propped up because they are the only ones that have the "specfii…c capital" to get us out of our current predicament. This is not an invalid argument. Neither is it unique to the current situation. Whenever the incentives to compromise integrity, to sacri…ce the quality, and to take unnecessary risks are there, most companies will do so in tandem. And because the ex post vacuum of speci…fic skills, capital and knowledge that their punishment will create make such a course of action too costly for the society, all kinds of punishments lose their effectiveness and credibility.

One position that I have taken on this blog is that the executives of financial institutions that enjoy government backing should be subject to imprisonment for failure to adhere to the spirit of the law of maintaining safety and soundness. This position draws the ire of commenters, but several of the points Acemoglu has brought up are points that lead me to take this view.

First, there is the fact that regulatory incentives degrade over time, and banks start to game the system. This means that "letter of the law" regulation is bound to fail, because over time banks will naturally find ways to take excessive risks that are within the letter of the law. Second, there is the risk disclosure problem--it is very had to design disclosure mechanisms that are fully protective and yet still allow financial intermediaries to perform their function. Third, there is the fact that the government cannot credibly commit itself to allow large institutional failures. As Acemoglu points out, there is too much "specific capital" in these institutions. Policymakers were afraid to shut down Freddie and Fannie completely, because they had become such a dominant source of funds for mortgages.

I think that financial institutions that enjoy either explicit government backing or a "too big and interconnected to be allowed to fail" status ought to have their executives worry that if they mismanage the institution they could wind up in prison. That would get them to care more about preserving their "reputation capital."

from a policy and welfare perspective, it should be self-evident that sacrfii…cing economic growth to deal with the current crisis is a bad option.

Acemoglu is saying that an economic downturn is nothing compared to institutions that promote or retard long-term growth. Of course, that is anything but self-evident to people who are ready to throw capitalism under the bus because of the latest unemployment statistics.

Because of the reallocation and creative destruction brought about by economic growth, there will always be parties, often strong parties, opposed to certain aspects of economic growth.

...The United States is not Indonesia under Suharto or the Philippines under Marcos. But we do not need to go to such extremes to imagine that when the …financial industry contributes millions to the campaigns of Senators and Congressmen that it will have an acute influence on policies that influence its livelihood or that investment bankers setting up--or failing to set up as the case may be--the regulations for their former partners and colleagues without oversight will likely lead to political economy problems.

...Market signals suggest that labor and capital should be reallocated away from the Detroit Big Three and highly skilled labor should be reallocated away from the …nancial industry towards more innovative sectors. The latter reallocation is critically important in view of the fact that the Wall Street attracted many of the best (and most ambitious) minds over the past two decades and we now realize that though these bright young minds have contributed to fi…nancial innovation, they also used their talents for devising new methods of taking large risks, the downside of which they would not bear. Halted reallocation will also mean halted innovation.

Here, we get to the "public choice" problems of bailouts and stimulus. Whatever the theoretically optimal policies might be, the impetus in practice is to reward the politically well-connected.

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The author at Economics Unbound in a related article titled Acemoglu on Growth and Innovation writes:
    Daron Acemoglu, whom I identified here as one of the leaders of innovation economics, has written a paper titled The Crisis of 2008: Structural Lessons for and From Economics. It's being widely quoted and criticized. Mark Thoma has a post... [Tracked on January 14, 2009 6:10 PM]
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RJ writes:

"In our obliviousness to the importance of market-supporting institutions we were in sync with policymakers. They were lured by ideological notions derived from Ayn Rand novels rather than economic theory. And we let their policies and rhetoric set the agenda for our thinking about the world and worse, perhaps,
even for our policy advice. In hindsight, we should not be surprised that un-regulated profit-seeking individuals have taken risks from which they benefit and others lose."- Acemoglu

Are you sure you meant to post this Kling? Are you not afraid of offending your virulent anti-government followers? Since when did you brainiacs at GMU become institutionalists?

I feel like next time I look at this blog I'll find Bryan referencing Galbraith's "A short history of financial euphoria".

Jeff writes:
The intellectual argument for the fi…nancial bailout of the Fall 2008 has been that the organizations that are clearly responsible for the problems we are in today should nonetheless be saved and propped up because they are the only ones that have the "specfii…c capital" to get us out of our current predicament. This is not an invalid argument. Neither is it unique to the current situation. Whenever the incentives to compromise integrity, to sacri…ce the quality, and to take unnecessary risks are there, most companies will do so in tandem. And because the ex post vacuum of speci…fic skills, capital and knowledge that their punishment will create make such a course of action too costly for the society, all kinds of punishments lose their effectiveness and credibility.

This is only true if all, or almost all, financial institutions compromised their integrity and need bailing out. But there are a number of banks that did not, and by propping up the bad banks, we are preventing the good banks from killing off the bad ones through competition. Bad behavior is not being punished, nor sound business judgment rewarded, and the result can only be to ensure that the next financial crisis will occur sooner and be even worse.

William Black believes that control fraud has played a large part in creating this mess, and he has also pointed out that historically, almost all such frauds have been discovered only after they ran their organizations into the ground. The forensic accountants and/or bankruptcy trustee then move in and find the evidence. Fraud discovery by outside auditors and regulators of a going concern almost never happens. By not allowing large firms to fail, we are helping the perpetrators of highly lucrative crimes get away with their loot. This has to result in even more such crime in the future. Such is the path to a banana republic.

Maniel writes:

Prof. Kling wrote that Acemoglu wrote: "We believed that through astute policy or new technologies, including better methods of communication and inventory control, the business cycles were conquered. Our belief in a more benign economy made us more optimistic about the stock market and the housing market. If any contraction must be soft and short lived, then it becomes easier to believe that financial intermediaries, firms and consumers should not worry about large drops in asset values."

This paragraph does not stand alone. It's not obvious who "we" refers to. It obscures for me the abstractions that the housing and stock markets represent. When I buy a house, I assess whether, based on many factors, it represents good value and I assess whether I can afford it. Its resale price is important when I resell it, but as part of the larger environment, "the housing market," that transaction is likely to be offset by the next house I buy (whose asking price will have risen or fallen along with my resale roughly in line with market conditions).

Similarly, the stock market is an after-market for shares issued to raise capital by offering equity in an enterprise. If the market is relatively high (by fundamental or historical measures), it signals that equity in private companies is prized and that businesses can finance growth by sharing ownership rather than taking on debt.

In each case, there is a recurring benefit to ownership - homes provide shelter and stocks provide a share of business revenues. The after markets hold the potential of capital gains, but any investor will tell you that those gains (or losses) are speculative. That whole industries have grown up around these after-markets is testimony to the remarkable growth in private and public debt.

All Mi T writes:

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John Seater writes:

Daron has a lot of interesting things to say, but he clearly also has fallen for the misleading reports in the media telling us that it was the markets that failed, not the regulations that distorted the markets in the first place. On p.13 of his paper, Daron says explicitly that the failure was one of unregulated markets. Is he kidding? The financial markets are unregulated? Let's get serious. Nowhere in the paper does Daron discuss Fannie Mae and Freddie Mac, the Community Reinvestment Act, or Sarbanes-Oxley. Those are institutions, you know, and they were counterproductive. Sarbanes-Oxley, by the way, was a recent *increase* in regulation. Daron also does not mention that there seems to have been only one legislative deregulation of the financial industry in the last 20 years or so, which was the partial repeal of Glass-Steagall that actually helped cushion the banking turmoil in August and September. The main recent regulatory omission seems to have been some way of preventing pyramiding of financial derivatives.

Daron is absolutely right of course that some regulation is needed, but we have a lot of evidence that much of the regulation that is in place was bad, not good. I expect economists much less reasonable that Daron (e.g., Stiglitz, the man who never met a market failure he didn't like) to be blind to government failure, but I am disappointed that Daron also seems blind to it. It is all around us, all the time. That is why government should intervene only in fairly extreme cases. There usually is a market cure for most market failures, such as the invention of UHF, cable, and satellite television that ended the VHF oligopoly on broadcasting and the internet introduction of cheap competition in the telephone industry. We can all think of lots and lots of other examples. A big problem with government failure, in contrast, is that there is no entry by competitors with better ideas. Try starting your own alternative government and watch what happens to you. That is why we have to be very wary of having government jump in even when there are obvious market failures. Government tends to institutionalize things (e.g., the bailout of the Big Three that Daron mentions in his paper), so even if there is a short-run benefit of an intervention, there may be a serious long-run cost in terms of legally preventing creative destruction.

We thus must proceed cautiously in advocating new regulations for two reasons: (1) regulations can suffer big time from government failure due to paying off influential lobbies, buying votes, and pure ignorance and foolishness, and (2) even regulations that correctly address a short-run problem may have long-run costs in terms of ossification that make the regulations undesirable on net.

Jeff writes:


It's one thing to decry new regulations as possibly unnecessary, but supervision of quasi-government agencies like Fannie and Freddie, or of FDIC-insured banks, is not an illegitimate function of government. When it comes to enforcing existing laws against fraud and theft in all their myriad forms, a decision to go easy on supervision is giving the green light to criminal behavior. In the financial world, the regulators are the cops on the beat. No one else has the expertise and information required to enforce the law.

Gary Rogers writes:

I will have to say that I was less than impressed with Acemoglu's essay. What I was able to take away from it is:

  • The cause of our current crisis is unregulated financial systems. This is the prevailing political talking point, not very inciteful and a point on which I personally disagree.

  • The diversification and counter-party relationships in our financial markets lulled us into a false sense of security by reducing volitility, but left us more vulnerable to long tail type catestrophic events. I do not disagree with this, but I am not convinced this was a significant cause for the crisis. I did not see any convincing explanation anyway.

  • Bailing out the financial system deprived the markets of its chance to self-adjust. This is a valid point, but again, nothing new.

  • We need to remember basic economic concepts and not throw away our chance for prosperity by falsely blaming markets for the present situation. This is the best point he makes and it should have been made with more clarity and less economic speak.

  • Finally, there is his belief that the government needs a stimulus package, a point with which I strongly disagree. Adding liquidity to the markets is one thing, but adding to an already overblown debt for a stimulus that will do more harm than good is irresponsible.

Just to give some insight into where I am coming from, I am not an economist so I find the writing style cryptic at best. However, I do expect the logic to be at least well laid out. In this case it was not. So, here I will throw out my own non-economic logic with the hope that it makes more sense:

  • Keynesean stimulus has been used off and on since WWII. It works by encouraging consumers and businesses to spend. This has the obvious consequence of also reducing savings.

  • When economic stimulus is applied year after year, savings throughout the economy begin to erode and businesses become more leveraged.

  • While savings are shrinking throughout most of the economy, the demographics of a baby boom generation on the brink of retirement has just the opposite situation with 401Ks and IRAs that are demanding high earnings. The best way to do this in a low interest rate environment is to increase leverage.

  • Our ability to conitnue with a stimulated consumption model for our economy was made possible by other countries who follow export models. They were more than happy to loan us money to finance our purchase of their exports. We took that borrowed money and continued our government deficit spending policies.

  • The housing bubble was a culmination of multiple stimuli, including low interest rates, tax deductions for mortgage interest, elimination of capital gains on homes, programs to provide low down payment mortgages, etc.

  • The bursting of the housing bubble was the trigger for our current financial crisis, but not the cause. The root cause was a financial system that was overleveraged and unable to sustain the economic shock of the housing problems.

  • Early August, 2007 found highly leveraged financial institutions looking at a rising sub prime foreclosure problem and new FAS157 rules that would force them to mark all of their mortgage backed securities to a non-existent market by November of that same year. I am speculating here, but it seems like this is where banks looked at their positions and knew they were in trouble.

  • The real crisis came when Hank Paulson made it clear that we were in big trouble by demanding a $700 billion bailout from the American taxpayers. Either you believed him when he said things were really bad or you did not believe him and knew the wrong people were in charge, but from that time on the question was not whether we were in trouble but how bad would things get.

  • Homeowners and financial markets are not the only segments of our economy that are carrying too much debt. The federal reserve is now leveraged at about a 50 to 1 ratio, more than Lehman Brothers when they went under. Of course the fed can print money, but that has its own set of problems.

  • For the government to borrow another trillion dollars or more for a stimulus package that has harmful long term consequences and increase an already dangerously high debt just does not make sense. It did not work for us in the 30's or for Japan in the 90's.

To me this makes economic sense and needs no translation, where Acemoglu seems to be wandering in details so he can expound on conventional wisdom yet avoid having to really explain anything.

Pete Murphy writes:

None of this discussion gets at the real root cause of the global economic melt-down: the global economy's utter reliance upon the U.S. running a massive trade deficit in perpetuity. With the U.S. continuously selling off assets to fund the deficit, it should have been obvious to anyone that the scheme would collapse as the supply of assets neared depletion. With virtually everything else sold off, the financial industry resorted to selling junk - securities backed by subprime mortgages that banks and government alike knew were doomed to default, just to keep the stream of foreign credit coming.

The question then becomes why economists' precious free trade theory and principle of comparative advantage failed so miserably when put to the test on a global scale. Perhaps if they were willing to consider the ramifications of huge disparities in population density from one nation to the next, they might understand why Ricardo's principle was flawed or, at best, incomplete. But then that would require them getting over their black eye from the whole Malthus ordeal. Probably won't happen, as it'd be career-suicide for an economist to approach the subject of population growth with an open mind.

Pete Murphy
Author, "Five Short Blasts"

John Seater writes:

I simply don't get the connection between Jeff's latest comment on my post and the content of my post. As far as I can tell, he and I agree that Fannie and Freddie did a crummy job. I regard Fannie and Freddie as government institutions. They were set up by the government and then given implicit subsidies by the government that effectively shut out competition. Calling them "quasi" simply hides their true nature. I regard their misbehavior as a fine example of a serious government failure. Furthermore, I see no market failure that ever justified the creation of Fran or Fred. We not need them. Indeed, we would be better off without them. They were one of the causes of the recent turmoil, which is no surprise given their protected status. The best way to "supervise" them is to close them down immediately.

Jeff seems to disagree with something I said, but I cannot figure out what that is or why he disagrees with it. For sure, I agree with everything he said in his earlier post about the foolishness of not letting firms fail and of not letting the market punish bad behavior.

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